Who to blame for the housing bubble (and crash)

Economy watch:  I like to invest by focusing on the big things and getting on the right side of the big trend.  There is alot of day-to-day noise that can distract me, and I try my best to tune it out.  This decade there have been four big things to get right, and if you got them right, you have invested well.  The four are: (i) the reversion of the dollar to its long term trend from its 2001 high; (ii) continued globalization; (iii) the rise of digital consumer technology; and (iv) the blow off top in the global real estate boom.

Today I will focus on the creation and bursting of the real estate bubble.  First a chronology:

  1. In 2001, the US experienced a recession during a period of extreme dollar strength and following the bursting of the telecom bubble, a credit crunch on businesses.
  2. The combination of a strong dollar and credit crunch created the threat of deflation, which the Greenspan Fed responded to by lowering the Fed Funds rate to 1%.
  3. Even when the credit cycle turned up, Greenspan kept rates at 1% for an extended period of time, resulting in an incredibly steep yield curve.
  4. A steep yield curve encourages high leverage.
  5. In the meantime, the dollar was starting to fall.  East Asian central banks propped up the dollar by recycling dollars used to buy their exports into US treasury and agency securities.
  6. With this inbound liquidity flowing and interest rates low, the credit boom was primed.
  7. The demand for credit investments encouraged the creation of asset-backed CDOs to satisfy investor demand.
  8. Low interest rates, easy money, positive demographics and a long running trend of positive residential real estate returns, encouraged a speculative frenzy in real estate.
  9. Armed with sophisticated math models using normal distributions for default rates, CDO sponsors convince the rating agencies to assign higher-than-deserved ratings for various tranches of the securities.
  10. Investors, relying on rating agencies because the complexity of the products was too opaque, were attracted to the securities for their relatively high yields (also due to lack of liquidity).
  11. Mortgage originators, incentivized to originate mortgages and sell them off, did what they were incentivized to do, albeit sometimes by cutting corners.
  12. In the meantime, the Fed is raising rates in predictable 1/4% increments.  The predicibility at first encourages speculation.  But since the credit boom and resulting inflation raged on, Bernanke kept raising rates to 5.5%.
  13. The housing bubble popped as high interest rates and high house prices reduced affordability.  Subprime borrowers began defaulting on their loans (that often had no equity down), house prices began to fall, credit hedge funds began running into trouble and the whole process started to go into reverse.

Everyone in the chain of events is to blame.  But I assign different levels of blame.

Whom I blame the most (because they created the incentives for the bubble):

  • Alan Greenspan (for not raising rates faster and sooner)
  • The Peoples Bank of China (for building currency reserves to  promote their own exports)
  • The rating agencies (for not realizing that defaults are correlated and that the model should have fatter tails)
  • Anyone who committed fraud

Whom I blame less (because they were reacting to conditions):

  • Borrowers (hey, they give me cheap money with no equity down, I’ll take it)
  • Mortgage Originators (hey, you pay me to sell you mortgages, no matter what the quality and with no documentation, fine, I can sell those all day long)
  • Wall Street (hey, we’re just doing what we always do)
  • Bond Investors (hey, the rating agencies said this was AAA)
  • Ben Bernanke (hey, there was an inflationary bubble going on, how can I not raise rates)

The housing crash still has a ways to go.  Demographics are now working against the market, and while house prices fall, its impossible to know what all the CDO securities are worth.  Of course its a vicous cycle, because as the financial institutions take write-offs to CDOs their equity bases shrink and general credit is restricted, which makes the economy worse and housing prices fall more, which in turn cuases more write-offs to CDOs.  Such a scenario is called DEFLATION.  Right back at ya, Greenspan.

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